Housing gain, retiree pain in cheap money

Investors in housing, equities, cash, floating-rate bonds and fixed-rate debt will all be anxiously awaiting the Reserve Bank of Australia’s next monetary policy decision. Changes in expectations for both short and long-term interest rates could have major ramifications for superannuation portfolios, as
Glenn Stevens
highlighted last week.

It has gone unnoticed so far, but the RBA governor’s seven-year term is up in 11 months’ time. Astute observers should not have been surprised that Stevens’s speech last Wednesday was distinctively reflective.

“A lot of people have gotten very used to very, very cheap money, not least their government, and that may create complications. We may well face a very long period of very, very low rates in these major countries, which I think is doing damage to the world’s retirement income system . . . because there’s no yield anywhere," Stevens said.

“I find that a bit troubling without being able to fully articulate what all the costs might be, but I think we will be discussing those potential costs of these policies over the years ahead."

Notwithstanding this emphasis on the risks of easy policy, Stevens’s speech was decidedly dove-ish and left the door wide open for a December 4 rate cut.

Stevens chose to reiterate a statement in the RBA board minutes, published on the same day, that “further easing might be required over time". And he observed that “looking ahead, the question [the board] will be asking is whether the current settings will appropriately foster . . . sustainable growth and inflation at 2 to 3 per cent".

The RBA has its doubts. Assuming the cash rate remains at its current level, the RBA is forecasting below-trend economic growth through to December 2014. The bank further claims that growth in the September quarter slowed from its above-trend pace of the past 12 months, consumption is below trend and leading labour market signals are quite soft. While core inflation was unexpectedly robust, the wage price index was on the low side. Benign labour costs are a precondition for a December cut.

The main economic issue for the RBA is whether the recent volatility in commodity prices and, more specifically, project delays and cancellations, will result in the resources investment boom peaking at a skinnier 8 per cent of gross domestic product, rather than the 9 per cent it previously projected.

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In September the RBA undertook “bottom-up" analysis of capital expenditure plans across the country. At the time, iron ore and coal prices were in free-fall. This due diligence led the RBA to revise its growth and inflation forecasts downward and precipitated the October cut.

While the RBA concedes it has front-end loaded a great deal of stimulus, the lags between policy changes and real economic effects mean it is still focused on ensuring that consumption and non-resources activity can step into the growth breach left by the proposed attenuation in resources spending next year. This is why the capital expenditure survey data to be released next Thursday is so important. It has the potential to confirm or invalidate the RBA’s downgrades. With the probability of a December cut now priced at 60 per cent, financial markets are – like the RBA – expecting to see materially adverse revisions.

Regardless of whether you agree with the RBA’s 1.5 percentage points worth of pre-emptive rate cuts in a period in which it says growth has been “above trend", we are stuck with cheap money.

In the RBA’s words, “average interest rates on outstanding housing loans [are] now about 75 basis points below the post-1996 average, while rates on small and large business loans [are] 75 and 125 basis points below average".

These are the rates on existing credit. Marginal rates for new borrowers are cheaper again. UBank is advertising an astonishingly low 4.79 per cent fixed-rate home loan. Its three-year fixed rate is just 5.13 per cent, a 40-year low.

While not all people realise it, the average bank deposit rate is now only 3.5 per cent (just covering the cost of living). You cannot get a 12-month term deposit above 5 per cent.

UBank’s famed “bonus" savings rate has slumped from 6.5 per cent to 4.9 per cent.

This is self-evidently good news for the $4 trillion housing market. Australia’s biggest mortgage broker, AFG, reported that it processed more mortgage applications last month than for any previous October and more applications than for any month since March 2009. And refinancing was not the explanation; loans to existing borrowers were at their lowest level since September 2009.

As forecast previously, Australian house prices have crept higher this year after falling 4 per cent last year. Since May 30, national house prices have risen at an annualised pace of 5.1 per cent, according to RP Data.

One of the best-performing markets has been Sydney, where house prices are up 3.1 per cent this year, and have inflated at a 9 per cent annualised clip since mid-May.

Other variables reinforce this story. RP Data tracks the difference between list and sale prices. As the chart shows, “vendor discounting" has been declining since the RBA started slashing rates. In July last year vendors were forced to drop list prices by 7.6 per cent to get a sale. Today they are discounting by only 6.8 per cent, which is in line with the average since January 2005.

Housing and equities will be the winners from further rate cuts. The big lurking risk for retirees is “fixed-rate" debt.

When the RBA eventually reaches the end of this easing cycle, markets will start pricing in medium-term rate increases. This is already starting to happen. The three-year Australian government bond futures rate has jumped from its 2012 low of about 2 per cent to 2.7 per cent today.

Investors in cash and “floating-rate" bonds will receive higher yields. But holders of fixed-rate bonds will suffer potentially significant capital losses. This is worth bearing in mind when building a diversified portfolio.